NACM Issue Brief and Suggested Enhancements to BAPCPA

on 01 May 2009.

The Bankruptcy Reform Act of 2005 made numerous changes to the commercial section of the Bankruptcy Code. The intent of these changes was to help offer protections to creditors as they worked with distressed and insolvent debtors as they proceeded through the Chapter 11 process toward rehabilitation. Although a good start, the changes fall short in some areas of achieving their intended purpose, namely the effort to restore the balance between debtor and creditor rights. Now, three years into the new code, there are specific areas that need to be refined or enhanced to better meet the intentions of the original changes. This includes the treatment of preferences (Section 547), treatment of claims for goods shipped within 20 days of the date of the filing (Section 503 (b)(9)), executory contracts (Section 365) and venue (28 U.S.C. Section 1409).

Background:As the largest organization of unsecured trade credit grantors in the world, NACM is vitally concerned about the effects that bankruptcy law and practices have on the U.S. economy. To this end, NACM has fought for bankruptcy reform laws that accurately reflect the needed balance between creditors and debtors. NACM was very supportive of the creation of the National Bankruptcy Review Commission (NBRC) because it believed that bankruptcy reform must be conducted in a thoughtful, deliberative environment. NACM worked diligently with the NBRC and with policymakers in Congress to highlight these problems and offer specific recommendaÂŹtions to address these inequities. Among the major issues of concern to NACM was Section 547 of the Code because of the abuse that continued to plague creditors who received legitimate payment from debtors for goods and services sold to the debtor.

Section 547 - Preferences:Under bankruptcy law, Section 547 of the Code requires that all payments made by a debtor to creditors within 90 days of a bankruptcy filing must be returned to the debtor's estate, unless the creditor can prove that the payment was made in the "ordinary course of business," that ânew valueâ was given, or that the transaction was a contemporaneous exchange for new value. The fundamental premise of this section of the Code is to prevent any one creditor from receiving favorable treatment over other creditors.

Typically, the trustee for the debtor's estate or more recently the liquidating trust under a Chapter 11 plan will issue demands to all creditors who received a payment in this 90-day period without regard to any of the defenses. The NBRC wrote that there is an argument that â âŠSection 547 leads to abusive preference recovery suits by bankruptcy trustees who bring actions indiscriminately, without properly analyzing the creditorâs available defenses, and to obtain settlements by creditors because of the litigation costs associated with defending these actions.â

The Commission noted the common practice for the trustee to send out a blanket demand and complaint to every creditor who received payments within 90 days of the bankruptcy filing. The trustee would have done little or no prior investigation other than to review the debtorâs check register and would have made no effort to determine whether the creditors have any valid defenses. It is rarely cost effective for the creditor to contest the action and most creditors enter into a negotiated settlement rather than incur the legal costs of defending the preference action. To make matters worse, there is no requirement that any funds returned to the debtorâs estate through preference recoveries are ever dedicated to satisfying the needs of the unsecured class of creditors. In fact, the NBRC concluded that over 90% of preference recoveries do nothing more than fund the recovery activities.

The NBRC and Congress also recognized the significant problems that existed for small business creditors who had few resources with which to fight blanket preference challenges. For this reason, BAPCPA made three changes to the Code:

It developed language to make it easier to prove the ordinary course of business defense by proving the transfer was either consistent with the âordinary course of businessâ between the debtor and creditor or consistent with industry terms;

It established a floor of $5,000 (since increased to $5,475 as a result of COLA changes) on preference claims; and,

It required that any preference challenge made for payments of under $10,000 (since increased to $10,950 as a result of COLA changes) must be brought in the jurisdiction of the creditor.

Unfortunately, very little has actually changed in the real world in the years after the enactment of these new provisions. There are no disincentives or sanctions preventing debtorsâ trustees from continuing to issue blanket preference demands and complaints for all payments made within 90 days of the filing. For the most part, it remains the small credit grantors who are unable to afford legal counsel to fight these preference claims. It remains more cost effective for the creditor, especially small creditors, to negotiate a return of some portion of the payment (without regard to appropriateness of the claim) than it is to incur legal expenses to fight the challengeâeven with the additional protections created in the 2005 law.

Recommendation:The trade creditor community believes that the abuse has not stopped and will not stop until the Code is modified. Specifically, we believe that if the onus to prove that a payment is indeed preferential is shifted, the blanket demands based on 90 day clock and the check register will stop. Under current law, the creditor is saddled with the onus to prove that the payment is not preferential. The Code offers nothing but encouragement to trustees to issue blanket challenges; there are no repercussions for trustees continuing to engage in this activityâeven if the payments to the creditor are legitimate.

The reality is that trade creditors face a double jeopardy: they lose funds due to the bankruptcy and are also forced to repay funds already collected. This simple fact has put some small companies out of business. Other credit grantors have been forced to adopt more rigid credit policies and have become less likely to continue offering credit terms that would help customers who show signs of distress.

The debtor or trustee should be required to prove that the payment is a preference, and a new provision should be included that requires the trustee to prove the transfer does not qualify as an ordinary course of business transaction. This change would allow for the deletion of the ordinary course of business defense, under Section 547(c)(2), which should be retained in its current form if the change is not adopted. This change is consistent with a fundamental tenet in American jurisprudence that an individual is innocent until proven guilty. Under current preference treatment, this fundamental principle is completely reversed. We believe that such a shift in the onus of proof will arrest the unscrupulous activities of many trustees who recover fees that only fund their own recovery activity. At a minimum, it will require the trustee to carefully consider any payment made to a creditor before issuing a blanket preference recovery demand because the trustee will recognize that the onus remains with the debtorâs estate to prove the claim. We believe this change will more thoughtfully restore the balance between debtor and creditor rights.

The trade creditor community also believes that all funds collected by a trustee on a preference claim should be distributed to all unsecured creditors. This change will further the goals of Section 547 to promote equality in treatment of unsecured creditors' claims and discourage trustees from pursuing preference claims to pay professional fees.

The trade credit community also proposes changing the new value defense under Section 547(c)(4) to settle a long-standing split among the courts on whether new value must remain unpaid to qualify for the defense. The Fourth, Fifth, Eighth and Ninth Circuit Courts of Appeal have allowed paid new value to be used as part of the new value defense if the payment is avoidable and not subject to any other preference defense. The Third, Seventh and Eleventh Circuits require that new value remain unpaid and the First, Second, Sixth, Tenth and D.C. Circuits have not ruled on this issue. Although there are lower court opinions that go both ways on this issue, the trend in court decisions is to allow paid new value.

The trade credit community suggests changing Section 547(c)(4) to allow trade creditors to deduct all new value extended to or for the debtorâs benefit during the 90 days before the bankruptcy filing. This is consistent with the net result rule that existed prior to the adoption of the Bankruptcy Code. This change will simplify the new value defense to avoid all the litigation that has been prompted by issues raised concerning this defense. This change will also encourage creditors to continue extending credit to a financially troubled company, replenish the debtorâs bankruptcy estate with new goods and services provided on credit and promote equality of treatment among similarly situated creditors, all policies that Congress had intended to further when it created the preference statute.

As a result of BAPCPA, Section 547(c)(9) of the Bankruptcy Code was added to protect business creditors from having to incur the expense of defending against small preference claims. These claims make no economic sense to bring and are intended to harass creditors into paying the full amount of the small preference claim or to settle the claim even where the creditor has a full defense in order to avoid the expense of retaining counsel to defend the claim. The trade creditor community applauds this change and recommends increasing the minimum preference claim that can be asserted against a business creditor to $10,000.

28 U.S.C. Â§1409(b) â Venue and Preferences:The trade creditor community supported the change by BAPCPA to the venue provision contained in 28 U.S.C. Â§1409(b). Trade creditors understood that the change was intended to require any small preference action against a non-insider business creditor be brought in the district where the creditor resides or does business. This is frequently not the same district as where the main bankruptcy case is pending. This change was also intended to discourage trustees from pursuing small preference claims by taking away their home court advantage and ending the practice of forcing creditors to pay or settle claims for which they have a defense in order to avoid incurring the expense of having to retain an attorney to defend a small preference in a far away court. As a result of this suggested change, the trustee has to incur the expense of bringing a small preference claim in the defendant's home court. However, some courts have ruled that the language of Section 1409(b) does not apply to small preference claims.

Recommendation:The trade creditor community recommends changing Section 1409(b) to make it clear that it applies to small preference claims up to the amount of $16,425.

Section 503(b)(9) â Administrative Priority Claims:The changes to the Bankruptcy Code in 2005 appeared to give trade creditors who supported the debtor in the 20-day period before the filing date a leg up in recovering the value of their shipments by making the claim an administrative priority claim. The changes stopped short of defining the process for payment of such claims resulting in an interpretation that payment can be delayed until confirmation of a reorganization plan, despite the fact that other administrative priority claims are being paid throughout the case. Secured lenders who had a lien on all of the debtorâs inventory also claimed a lien on the inventory shipped in this 20-day period, thereby taking a priority position over the creditors. Shipments in the 20 days preceding the bankruptcy did little more than support the secured lender on the backs of the trade creditors.

The wording of Section 503(b)(9) only addresses actual receipt of goods received in the 20-day window. Frequently in the period leading up to a bankruptcy filing the debtor will have reduced their headcount in favor of hiring temporary workers thereby eliminating the cost of benefits and transferring the obligation of employment taxes to the temporary help agency. Likewise, there are many service providers who support the debtor in the final 20 days by supplying services that go directly into their product or into the operation of the organization. These trade creditors should not be excluded from having an administrative claim for the work performed in the 20 days prior to the filing. The wording of Section 503(b)(9) should be changed to require immediate payment for goods delivered within 20 days prior to the filing in order to encourage creditors to continue extending credit while the company is in financial distress prior to the bankruptcy filing. Section 503(b)(9) should also more clearly define when goods and services are received in order avoid litigation on this issue.

Recommendation:Trade creditors who supply the debtor with goods and services on open account up until the time of the filing should not have to wait until the conclusion of the case to be paid. As other administrative expenses are paid throughout the case, the administrative priority trade claims should likewise be paid when they fall due. Suppliers of services used in the actual production and distribution of the product or in the ordinary operation of the debtorâs business should receive the same treatment as suppliers of goods. During at least 45 days preceding a bankruptcy filing the majority of debtors filing Chapter 11 are, or should be, fully aware that they are insolvent. Nonetheless, these debtors continue to acquire goods and services on credit terms all for the benefit of their secured lenders whose collateral position is improving as a result. These debtors are at the same time negotiating Chapter 11 financing arrangements with their lenders that grant the lenders first priority security interests in all of the debtorsâ assets. Clearly, the debtors are accepting these goods and services on credit terms under false pretenses. Trade creditors would not have extended credit during this time had they known of their customerâs insolvency or planned bankruptcy filing. Adequate remedy has to be provided to the trade creditors.

Section 546(c)(1) â Reclamation: In addition to the administrative priority claim offered by Section 503(b)(9), the Bankruptcy Code also provides trade creditors a remedy under Section 546(c)(1) on reclamation. This right was expanded under BAPCPA to include goods shipped within 45 days prior to the commencement of a bankruptcy proceeding, rather than the previous version of the Codeâs 10-day reclamation period. However, cases decided since the 2005 enactment of the BAPCPA have often come down against trade creditor rights and, very frequently, reclamation claims in Chapter 11 cases provide trade creditors little to no protection, even if those goods were shipped within the statutory 45-day period. Despite this fact, the trade creditor community still believes the current state of the reclamation provision is preferable to the one used prior to BAPCPA, but only due to the presence of Section 503(b)(9), which works as a safety net for creditors unable to assert reclamation claims. In the world of trade credit, these two statutes are inextricably linked, and the elimination of both the Section 503(b)(9) administrative priority claim and the expanded reclamation rights provided by BAPCPA would be a devastating blow to many unsecured trade creditors.

Recommendation:Section 546(c)(1) on reclamation should remain unchanged as long as a trade creditorâs right to an administrative priority claim under Section 503(b)(9) is preserved. Should Section 503(b)(9) be eliminated, the trade creditor community would require a second look at the current language of Section 546(c)(1) in order to see what changes could be made to ensure that the provision works as it was originally intended and provides adequate remedy to unsecured trade creditors.

Section 365 - Executory Contracts:The debtor is allowed time to review each executory contract and either reject the contract or accept it and pay any cure amount, the amount of prepetition debt owed on the contract. Oftentimes this can take several months and, in the interim, the trade creditor is compelled to support the debtorâs reorganization and rehabilitation by supplying more goods and services needed in the normal operation of its business. Trade creditors should not be required to continue to sell to the debtor on credit during this period. The extension of credit just piles more debt and risk of loss on the trade creditor. If, for any reason, the debtor is unsuccessful in its reorganization attempt and the case is converted to a Chapter 7, the creditor who extended credit during the case will still stand behind the secured lender and have little if any chance of recovering this new loss.

Recommendation:No creditor shall be obligated to continue to extend trade credit to a debtor subsequent to the commencement of a case under any chapter of this title.Section 366 â Utility Service: Section 366 was modified under BAPCPA to give utility providers a positive form of adequate assurance after commencement of a case. It is in both the debtorâs and the secured partiesâ interests to maintain services such as electricity, water, gas, telephone, Internet and trash removal in an uninterrupted fashion. Section 366(c) gives the debtor, trustee and service suppliers a reasonable choice of methods for assurance without overburdening either the debtor or the secured parties.

Recommendation:There should be no change to this section.

28 U.S.C. Â§ 1408 â Filing VenueWhere a case is filed can have significant impact on the outcome. By filing the case in a jurisdiction other than that of the main offices of the debtor creates a roadblock for participation by trade creditors and employees. Selecting a venue outside of the debtorâs location increases the cost of participation by the debtor when travel and housing costs are added to the case. It also takes the debtor away from the business location to participate in activities related to the case. The courts in the local jurisdiction typically have a better understanding of the debtorâs business and the local labor and financial environment.

Recommendation:The debtor should not be able to venue shop, looking for the court that will be most sympathetic to their case, but should file in the jurisdiction of their headquarters or primary operations. This will allow for more access to the case by the employees and local vendors as well as have the case administered by a court that is familiar with the company and operations.

SUGGESTED CHANGES TO THE BANKRUPTCY CODE

Section 547(b) is amended to add the following subsection 6, which replaces Section 547(c)(2).

(6)

that was not in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee; was not made in the ordinary course of business or financial affairs of the debtor and the transferee and was not made according to ordinary business terms.

The "and" between subsections 4 and 5 of Section 547(b) should be deleted and an "and" should be inserted between subsections 5 and 6.

Section 547(c)(4) of the Bankruptcy Code shall be amended as follows:that was not in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee; was not made in the ordinary course of business or financial affairs of the debtor and the transferee and was not made according to ordinary business terms.(4) to or for the benefit of a creditor to the extent that during the 90 days before the date of the filing of the petition, the creditor gave new value to or for the benefit of the debtor that is not secured by an otherwise unavoidable security interest. Section 547(c)(9) of the Bankruptcy Code shall be amended as follows:

(9)

If, in a case filed by a debtor whose debts are not primarily consumer debts, the aggregate value of all property that constitutes or is affected by such transfer is less than $10,000

Section 550 of the Bankruptcy Code shall be modified to add the following subsection (g):

(g)

If a trustee avoids a transfer of property under Section 547(b) and recovers such property or the value of such property from a creditor with a non-priority unsecured claim, then the proceeds from such recovery shall be separately held by the trustee for distribution on a pro rata basis to all creditors with non-priority unsecured claims.

28 USC Â§ 1409(b) shall be modified as follows:

(b)

Except as provided in subsection (d) of this section, a trustee in a case under title 11 may commence a proceeding arising under title 11 or arising in or related to a case under title 11 to recover a money judgment of or property worth less than $1,100 or a consumer debt of less than $16,425, or a debt (excluding a consumer debt) against a non-insider of less than $16,425, only in the district court for the district in which the defendant resides.

Section 546(c)(1) on reclamation: No change, provided that administrative priority rights for unsecured trade creditors are preserved under Section 503(b)(9).

Section 503(b)(9) is amended as follows:

(9)

the value of any goods or services received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been sold or services provided to the debtor in the ordinary course of the operation of such debtorâs business. All such allowed administrative expenses shall be immediately payable in accordance with the creditorâs terms of payment. Goods shall be deemed received upon the debtor taking physical possession of the goods, or, if the debtor does not receive physical possession of the goods, upon passage of title to the goods to the debtor. Services shall be deemed received on the date the creditor renders such services

Section 365 is amended to add a new subsection g.

g. Notwithstanding any provision to the contrary in any executory contract, no creditor shall be obligated to continue to extend trade credit to a debtor subsequent to the commencement of a case under any chapter of this title.

Section 366 on utility service: No change

28 U.S.C. Â§ 1408 shall be amended to eliminate the following:

Except as provided in section 1410 of this title, a case under title 11 may be commenced in the district court for the district â

(1) in which the domicile, residence, principal place of business in the United States, or principal assets in the United States, of the person or entity that is the subject of such case have been located for the one hundred and eighty days immediately preceding such commencement, or for a longer portion of such one-hundred-and-eighty day period than the domicile, residence, or principle place of business, in the United States, of such person were located in any other districts; or

(2) in which there is pending a case under title 11 concerning such personâs affiliate, general partner, or partnership.

And replace with the following: 28 U.S.C. Â§ 1408 (A) Except as provided in section 1410 of this title, a case under title 11 may be commenced in the district court for the district â

(1) in which the domicile, residence, principal place of business in the United States, or principal assets in the United States, of the person or entity that is the subject of such case have been located for the one hundred and eighty days immediately preceding such commencement, or for a longer portion of such one-hundred-and-eighty day period than the domicile, residence, or principle place of business, in the United States, of such person were located in any other districts;

(2) in which a case under title 11 concerning the controlling corporation is pending, if â

(A) the debtor is controlled by another corporation;

(B) within the 730 days before the date of the debtorâs filing under title 11, the financial statements of the debtor have been consolidated with those of the controlling corporation in 1 or more reports filed under section 13 or 15(d) of the Securities Exchange Act of 1934; and

(C) the controlling corporation is a debtor in a proceeding under title 11; or

(3) in which a case under title 11 concerning the controlling corporation is pending if â

(A) the debtor is a corporation other than a corporation described in paragraph (2);

(B) the debtor has been controlled by another corporation for not less than 365 days before the date of the filing of the debtorâs petition under title 11; and

(C) the controlling corporation is a debtor in a proceeding under title 11.

(B) For purposes of subsection (a) --

(1) if the debtor is a corporation, the domicile and residence of the debtor are located where the debtorâs principal place of business is located and

(2) the term âcontrolâ has the meaning given that term in section 2 of the Bank Holding Company Act of 1956 ( 12 U.S.C. 1841).â

SEC.2. CURE OR WAIVER OF DEFECTS.

Section 1406(c) of title 28, United States Code, is amended to read as follows:

(c) As used in this section â

(1) the term âdistrict courtâ --

(A) includes the District Court of Guam, the District Court of Northern Mariana Islands, and the District Court of the Virgin Islands; and

(B) with regard to cases pending before a bankruptcy court, includes a bankruptcy court; and

(2) the term âdistrictâ includes the territorial jurisdiction of each district court.â